Sales Tax Levies on Digital Downloads Facing Headwinds for Now

It is hard for legislators in cash-strapped states to ignore the explosion in the use of electronic devices - handheld computers, smart phones, iPods, iPads, and e-readers - and not view the many products these devices deliver as a basis for a new sales and use tax. A few states already tax some digital downloads that they define as personal property, such as books or films that might be sold in other formats in stores with a physical presence, or a nexus, in their state.

Collecting sales tax through remote Internet sellers has been difficult, as large Internet retailers challenge the legal basis for a sales tax in states where they claim they have no physical presence. As lawmakers consider the scope of a digital downloads tax and debate the potential impact on businesses and individuals, it has become apparent that taxing electronic transfers will not be an easy solution to revenue problems.

Recently in Maryland, bills that would have extended the state's sales tax to include any product that is electronically downloaded were rejected in the Senate and the House. "The digital download tax was so broadly written that it could have applied to e-filing, accounting services provided over the Internet, and all purchases of business and accounting software (even SAAS and cloud apps)", Maryland Association of CPAs (MACPA) Executive Director Tom Hood explained in an exchange with AccountingWEB.

The biggest risk the MACPA saw is that the bill could have been construed to include e-filing of tax returns, but Maryland CPAs opposed the bill for other reasons as well:

It amounts to a tax on taxes. Marylanders would be forced to bear a tax on top of CPAs' services when they need to file taxes.

Nonprofit organizations might be forced to tax educational programs, such as webcasts and other "digital products", putting themselves at an unfair business disadvantage with out-of-state and for-profit organizations.

A bill introduced by Connecticut's General Assembly's Finance, Revenue and Bonding Committee would have consumers pay the state's 6.35 percent sales tax on any electronic transfer of a digital product that grants the purchaser "a right or license to use, retain, or make a copy." This could extend to books, iTunes downloads, and ringtones. Connecticut's governor, a democrat, does not support the bill, and it is not expected to be brought before the legislature.

Some states have already imposed some kind of tax on digital products, taking the position that certain digital products were taxable under existing statutes applicable to tangible personal property or specified taxable services. Connecticut, for example, already taxes computer services.

In an effort to reduce uncertainty about which products were taxable, amendments were made to the Streamlined Sales and Use Tax Agreement (SSUTA), effective in 2010, providing that the twenty-five states that had signed on to the Agreement may not tax "specified digital products" pursuant to their statute applicable to tangible personal property. "Specified digital products" were defined to include digital-audio visual works, digital audio works, and digital books.

SSUTA signers would then have to specify in law that these items were taxable. Further, the 2010 amendment made the restriction applicable to all other products "transferred electronically", according to a KPMG State and Local Tax publication",Sales and Use Taxation of Digital Products."

Some states, relying on the SSUTA restrictions, have passed legislation specifying digital items that are subject to tax. But individual states tax different items, and overall, there continue to be many different approaches to taxing downloads.

As a result, businesses that sell in multiple states are left to cope with complex compliance issues. South Dakota, for example, taxes all products transferred electronically. New York law imposes a sales and use tax on tangible personal property (including prewritten software) and certain information (and other) services. e-books are not taxed because they are not tangible property and they do not include any prewritten software.

Whether or not a purchaser pays a sales tax on an e-book seems to be in a state of flux. Amazon charges sales tax on e-books in states that claim nexus, but adding to the confusion, in 2010, it announced: "Several publishers have recently changed the nature of their relationship with Amazon, moving to a business model whereby the publisher, not Amazon, is the seller of record for their books. Kindle books sold under this model are subject to sales tax based on the publisher's state tax reporting obligations and the taxability of digital books in those states."

Changes in technology move much faster than changes in state law. According to the authors of the KPMG study, this results in "potential uncertainty and risk for purchasers and sellers, a diminution of state tax bases, and dissimilar tax treatment for similar transactions and products."

Despite the recent failures of digital download tax bills, the Main Street Fairness Act of 2011, which is now before Congress, is a sign that consumers and businesses can expect more proposals to tax Internet sales as well as the sales of digital products in the near future.